Ken Moody muses over what is allowable as ‘enhancement’ expenditure for capital gains tax purposes, and encounters what seems to be a proverbial ‘Catch 22’ situation.
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HMRC regards the capital gains tax (CGT) provisions of TCGA 1992, s 38 (acquisition and disposal costs, etc.) as exhaustive. So, if an item of expenditure is within any of the categories of expenditure identified at section 38, it is allowable; if not, then it is not allowable.
Is it an ‘enhancement’?
One such category is ‘enhancement’ expenditure, being (slightly paraphrased): Expenditure wholly and exclusively incurred on the asset by or on behalf of the owner, for the purpose of enhancing the value of the asset, being expenditure reflected in the state or nature of the asset at the time of disposal.
A ‘wholly and exclusively’ test sets a rather high bar to allowability, though I interpret this as referring to being spent ‘on’ the asset and not on anything else.
HMRC gives an example of payments made by a parent company to employees of a subsidiary to secure their resignations, as required by the purchaser of the shares in the subsidiary. The payments are made in connection with the sale of the shares, but are not on the shares themselves,and so do not qualify as enhancement expenditure for the parent company (see HMRC’s Capital Gains Manual at CG15180).
HMRC’s guidance notes: ‘This looks at the purpose for the expenditure, not whether there is actually an enhancement of value.’
In Aberdeen Construction Group Ltd v CIR [1978] 52 TC 281, Lord Emslie stated: “…what [Section 38(1)(b)] is looking for is, as the result of relevant expenditure, an identifiable change for the better in the state or nature of the asset, and this must be a change distinct from the enhancement of value”.
This makes sense in relation to the shares in the subsidiary in the earlier example, which might have been enhanced through making payments to employees of the subsidiary, and may have passed the purpose test. However, the payments do not affect the state or nature of the shares themselves.
What’s the purpose?
HMRC also gives an example of ‘Mr T’ who buys a plot of land for £200,000, builds a tennis court on it costing £5,000 and later demolishes the tennis court and incurs £20,000 on building a swimming pool. He then sells the property. The £5,000 cost of the tennis court is not allowable expenditure as not being reflected in the state or nature of the asset (i.e., the land) on disposal.
We are not told Mr T’s purpose in incurring either item of expenditure. Suppose, for example, Mr T also owns a factory which is running out of space for the needs of the business, so he builds an extension. The work might well enhance the value of the property, but Mr T’s immediate purpose is to provide additional space for his business operations. The only situation I can imagine where enhancement of value is the sole purpose of incurring expenditure is where the asset is purely an investment asset, such as buying the freehold of a leasehold property.
Whether expenditure is reflected in the state or nature of an asset at the time of disposal ought generally to be self-evident. Establishing the taxpayer’s subjective purpose in incurring that expenditure, possibly many years after the event, is where my ‘Catch-22’ reference seems apt.
Practical tip
Perhaps there is a clue in HMRC’s example. It is unclear whether Mr T’s sole purpose in incurring expenditure on the swimming pool was to enhance the value of the property. However, since he is not required to show any actual increase in value (though it might help), and since the expenditure on the swimming pool was reflected in the state or nature of the property on disposal, it seems unlikely that HMRC would seek to deny relief by enquiring into the purpose of the expenditure.
